Substance Over Form: What It Means for Business Operations

In the world of business and corporate governance, the principle of “substance over form” holds significant importance, particularly when it comes to determining the legitimacy of a company’s activities in a given jurisdiction. This concept emphasises that the economic reality of a business’s operations should take precedence over the mere legal form or structure under which it operates. In this article, we will explore what “substance” means in the context of corporate governance and the implications for businesses operating in jurisdictions like Malta, where substance is critical for tax and regulatory purposes.

Understanding Substance Over Form

At its core, “substance over form” means that the actual business activities, operations, and decision-making processes should reflect the company’s true operational and economic base, not just the legal or contractual appearance of where it is registered or incorporated. In today’s evolving tax landscape, where changes are frequent and significant, maintaining substance is more crucial than ever.

For example, a company may be incorporated in a low-tax jurisdiction, but if its activities and decision-making are happening elsewhere, it may be seen as lacking substance in that jurisdiction. Tax authorities are increasingly scrutinizing whether companies truly have substantial operations in the jurisdictions where they claim to be registered, as opposed to merely taking advantage of favourable tax rates without contributing to the local economy.

The Importance of Substance in Corporate Governance

Corporate governance and operations must be aligned with the reality of business activities, and in many countries, this alignment is scrutinized by tax authorities. A company claiming tax residency in a jurisdiction, such as Malta, must demonstrate that it is not simply a shell company, but one that is actively conducting business with real economic activity in that jurisdiction. In Malta, for instance, local authorities are keen to ensure that companies registering there are not only doing so for the purpose of benefiting from tax advantages but are also contributing to the local economy in a meaningful way

Key Elements of Substance in Malta

For businesses registered in Malta, several factors contribute to proving that the company has substantial operations within the country. These include:

1. Local Director: Having local director/s in Malta is a key element in demonstrating substance. The director/s should be involved in the strategic decision-making of the company, ensuring that key decisions are made locally, rather than being dictated from another jurisdiction.
2. Local Bank Account: Opening and maintaining a local bank account in Malta shows that the company is conducting its financial activities in the jurisdiction. It provides an additional layer of evidence that the company is not simply a shell but is engaged in economic activity in the country.
3. Office Space: Operating from a physical office in Malta further supports the substance of the business. This can demonstrate that the company is engaged in operational activities within the jurisdiction and is not merely using the country as a location for registration.
4. Employees in Malta: Employing staff locally adds another important layer of substance. The presence of employees, who are actively working and contributing to the company’s operations, is critical for establishing that the company’s economic activity is based in Malta.
5. Decision-Making in Malta: It is vital that significant decisions for the company are made and approved in Malta. Whether it’s approving financial statements, major contracts, or strategic directions, the company should show that its key decision-making processes occur at its registered address in Malta.

The Risk of Lacking Substance

If a company is found to lack sufficient substance in Malta—meaning it does not have the necessary economic activity and operational presence within the jurisdiction the foreign tax authorities may rightfully claim a portion of the company’s profits. This is often referred to as a “permanent establishment” (PE), which refers to a business’s fixed place of operation in a jurisdiction. A company with a PE is subject to taxation in that jurisdiction on the profits attributable to the activities conducted there.

For example, if a company is registered in Malta but carries out all of its significant activities and decisions in another country without any meaningful operations in Malta, the authorities in the other jurisdiction may argue that the company is effectively operating there, rather than in Malta. As a result, the foreign jurisdiction may assert that the company has a permanent establishment, and therefore, the profits derived from activities in that jurisdiction may be subject to foreign tax laws, potentially resulting in double taxation issues or additional tax liabilities.

The Importance of Compliance and Good Governance

Adhering to the principle of substance over form is not only important for tax compliance, but it also reflects good corporate governance. A company that genuinely operates in the jurisdiction where it is registered is more likely to be seen as a credible and legitimate entity by both local regulators and international tax authorities. Proper governance and substance also protect the company from potential legal challenges or accusations of tax avoidance.

For businesses in Malta or any other jurisdiction, maintaining substance is critical to ensuring that the company’s tax obligations are met, and that it remains compliant with local and international laws. It also reinforces the company’s legitimacy, contributes to economic growth, and fosters trust with regulators and stakeholders.

Conclusion

Ultimately, ensuring that the substance of a business aligns with its form is not only about avoiding tax penalties; it is about building a sustainable, transparent, and accountable business that thrives in its operating jurisdiction.

Zampa Partners provides corporate services through ZD Corporate Services Limited which is authorised to act as a Company Service Provider by the Malta Financial Services Authority